The Real Deal

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Investors defaulting to make money

For most homeowners, foreclosure is like a fatal illness that starts with losing control of their finances and ends with a sickening feeling when the bank finally seizes the property. Post-foreclosure, a homeowner's credit rating gets trashed and he can be in financial purgatory for years, making it nearly impossible to buy or rent property.

But while foreclosure typically spells disaster for homeowners, for some New York City investors, it may actually be a good business decision.

Indeed, foreclosure doesn't have to be a money-losing proposition, especially for the small-time investor who borrowed money to buy townhouses or condominiums, according to Augustine Diji, a Manhattan-based lawyer who helps investors drag out the foreclosure process for as long as possible.

A depreciating real estate market and adjustable-rate mortgage resets have changed the equation for many of Diji's clients, who include a tenured college professor as well as a restaurant owner. Instead of making mortgage payments, these investors are voluntarily choosing to go into default, sometimes before they are in dire straits financially, and pocketing all the rental income they can.

It is not just investors who are walking away from their financial obligations.

The crash in real estate values is prompting a significant number of property owners in general to make "strategic" decisions to default on their mortgages, according to a recent study by the University of Chicago's Booth School of Business and Northwestern University's Kellogg School of Management. The study found that 26 percent of mortgage defaults were by homeowners who had money to continue making payments, but had chosen to not to.

But investors have much less incentive to hang onto their properties.

For many investors with properties that are about to be underwater, it doesn't make sense to continue making mortgage payments, said Diji, who is generally able to buy his clients an extra year in foreclosure before the banks finally seize the property.

"The smart people say this is a great way of getting equity from a property," he said. "Because you cannot refinance it, you can never sell it, it is depreciating, and it is going to be upside-down at some point — so you just take the cash flow and let the bank eat the loss."

While low-income homebuyers in New York City dominate the foreclosure rolls, many well-heeled investors in condos and small multi-unit rental buildings are joining their ranks. Lis pendens, or preliminary foreclosure notices, were filed on 194 non-owner-occupied condos in the five boroughs in the first two quarters of 2009. That was 23 percent of the total citywide lis pendens, according to PropertyShark.

For townhouses, there were 806 lis pendens notices filed for non-owner-occupied two- to four-family dwellings in the first two quarters of 2009, 14 percent of the total citywide.

In contrast to many of the homeowners facing foreclosure who simply cannot afford their mortgage payments, a lot of investors in default are still flush.

One of Diji's clients has one four-family and two three-family rental properties that he purchased, each for about 10 percent down. The client, Diji said, has already taken out at least half a million dollars in equity out of his buildings by refinancing them. And although all of his rental properties are currently performing with profit, the investor has stopped making his mortgage payments and hopes to clear more than $200,000 after he is served with foreclosure papers.

"He has the type of mortgage where every single payment goes to interest, so it is not as though he is going to see some equity anytime soon," Diji said. "The mortgages all have adjustable-rate features, which means that they will go up at some point. He is not concerned about credit because he wants cash. And the only way that he can get cash is not to make any more mortgage payments, collect all the income and bank it. He wants to do it as long as he can, and that is where I come in."

Diji said another of his clients makes at least $500,000 a year, but since he is nearing retirement, he has decided to cut his losses.

"He doesn't want to keep these humongous payments of $11,000 a month — who does?" Diji said. "The interesting thing about this person, and I have quite a few clients [approaching retirement], is that their perspective is, 'I cannot afford to throw away my cash and hope the market goes up. I have to retire and this doesn't make sense for me.'"

Going into foreclosure and stripping a property for all its worth is not a new strategy, said Joshua Stein, chair of the education committee of the Mortgage Bankers Association of New York and a partner in the real estate practice group of Latham & Watkins.

"It is a famous technique for small-time real estate investors," Stein said. "You know you are going to lose the property, so … you put as much in your pocket as you can."

During the last real estate downturn in the early 1990s, many investors were going into default and milking their properties for all the available cash.

Back then investors were able to shield themselves from personal liability through special types of partnerships. But since that financial debacle, the banks have taken steps to protect themselves on big commercial deals.

Typically substantial commercial deals involve "non-recourse carve-outs," where banks require that an individual sign an agreement that makes him liable in the event the partnership or limited liability company pulls money out of the property or damages the property.

In riskier deals, banks often require a "lockbox," where the tenants make rent payments directly into an account controlled by the bank, and funds first get applied to paying building expenses and debt service, after which the balance goes to the owner. In the most extreme lockbox, the owner doesn't get to touch any money until all the obligations have been paid.

However, lockboxes and non-recourse carve-outs will often not be required in smaller deals, Stein said.

Further, in many cases, investors may own their properties under the name of a limited liability company. Stein said if the investor has an LLC, "nobody has any obligations on the note except for the LLC itself, and if you own the LLC and know you will soon lose the building, you can distribute all the money out at the end of the month and you make sure that the money is artificially high, because you are not paying anything that you should be paying."

Even in situations where the investor's name is on the mortgage document, chances are they will still be able to walk away with the cash, explained Stein.

Lenders generally have the perspective of, "'I notice this guy got six months of rental income, say $5,000 a month. How likely am I to go hire a lawyer to chase this guy and file a lawsuit?'" said Stein.

When investors stop making their mortgage payments, they often stop paying building expenses as well and allow their property to fall into disrepair, said Stein.

Still, Diji said many of his clients are simply inexperienced investors who got caught up in the real estate euphoria of the past decade.

"In Manhattan, especially, people were buying because it was the gold train and brokers were pushing, 'Buy this second property pied-à-terre and have cash flow all day long — and you can flip it because it is worth all this money.'"

He said some of them fell victim to option ARMs, a financial product that savvy speculators have used with success, but which for the first-time investor was like a novice driver getting into a racecar.

And going into foreclosure is a tough decision for many investors.

"You have to have a thick skin," said Diji. "We have it built into our [psyches] — 'I made a deal to pay, and it is wrong not to pay,'" he said. "That type of moral thing, you are going to have to get over."

"You have to do what the banks are doing," he said. "The banks have terrible credit, they have no money, but they are essentially leveraging everything and getting free money."

Ultimately, it's the banks that stand to lose money on over-leveraged properties that go into foreclosure.

Stein said, "If you are the borrower and your lender did not impose a lockbox or a recourse carve-out guarantee, and if your property is not throwing off enough income, then you say to yourself, 'Why not do what the law lets me do?' Take the money and run."